PPI numbers were released today and producer prices are up year on year by 8.2%, which is higher than April’s 8.1% and March’s 8.0%. Coal, steel, and energy price increases drove the jump in PPI. Although everyone expects May’s CPI inflation number, which will be released tomorrow, to be 7.7%, much lower than April’s 8.5%, I suspect that the continued acceleration of PPI is going to overshadow the good news on CPI, as it should. The fear, and a very plausible one, is that factories are going to pass on their cost increases to consumers, so spreading inflation out of food and into non-food prices. The reduction in CPI prices is likely to be very temporary, and we will probably see prices resume their upward climb by July or August.
The RMB strengthened today on comments by a government official about the need for currency flexibility to combat inflation. According to today’s South China Morning Post, Xu Lianzhong, a price monitoring official at the NDRC, wrote an article in the China Securities Journal yesterday that argued that the RMB should be permitted to appreciate faster to ease inflationary producer price pressures. For the past few months there has been a constant back-and-forth in the press among different government officials on the subject of the RMB. My guess is that the continued increase in PPI prices is making it easier for the monetary alarmists to make their case, although at this point I am very pessimistic that anything can be done soon enough to avert a very difficult adjustment when it finally comes.
As I have argued many times before, I think the key to controlling inflation is to control domestic money creation or, in other words, to slow the massive amount of inflows into which China’s currency regime has locked the country. With appreciation pressures so strong, it is pretty clear that various forms of hot money have become the engine of money creation. Iit used to be the trade surplus that powered reserve growth, but the unexplained amount – after the trade surplus, FDI, currency valuations, interest income and all the other easily explained things are removed – is now by far the biggest component of reserve growth, and even this understates its impact because there is increasing evidence that a large and growing part of FDI and the trade accounts are also simply disguised hot money. In this context, one of my eagle-eyed readers sent me a link to this fascinating article from today’s Dow Jones Newswire:
SOFIA (Dow Jones)–Copper has become an instrument by which hot money flows into China but this has created the false impression that Chinese consumption has taken off, Wu Yuneng, general manager of JCC Southern Group Company, said Wednesday. Noting that investors are looking to capitalize on interest rate differentials between the renminbi and dollar, Wu said copper is being used as a tool for foreign exchange gains.
Financing and foreign exchange arbitrage means that copper cathode imports are large even when the arbitrage between the London Metal Exchange and the Shanghai Futures Exchange is negative, Wu said, speaking through an interpreter at the Metal Bulletin copper conference in Sofia.
Although refined copper imports declined in the first quarter, the quantity of metal imported for financing purposes was relatively stable, Wu said. The quantity of copper imported in February accelerated the decline in LME stocks, he noted, and adequate supplies in China are making Shanghai prices underperform the LME. According to Wu, expectations of a tightening monetary policy in China mean copper is also being imported to be sold on the domestic market to raise quick cash.
Evidence for this copper financing play can be seen in data from the Chinese Commerce Department, he noted. This showed Chinese foreign exchange reserves in the first quarter amounted to $1.68 trillion, an increase of 40%. Even accounting for a net surplus of foreign trade and foreign direct investment, $85.1 billion cannot be explained, said Wu.
Today, before I had a chance to read this article, I had lunch with the very smart Jing Ulrich of JP Morgan, and four other guests, and one of the things we discussed was exactly how hot money was entering into China, and whether there were realistically things the government could do to stop it. I was pessimistic about the latter. It seems to me that very large countries with very active trading borders and long histories of capital controls have very deep channels for money flow, both into and out of the country, and any serious attempt to disrupt these flows is also likely to be seriously disruptive to real economic transactions. For a while I had been considering the idea that gold trading might be one avenue of capital inflow, but from Mr. Wu’s comments it seems that there are a lot of ways metal trading (and other commodity trading) can serve the purpose of hot money.
To stop this kind of transaction would require an extremely onerous monitoring of what must be hundreds of transactions every week in which large and small commodity-related trades occur. That might slow speculative capital inflows (at least through this particular channel), but it would probably also interfere with necessary economic transactions and impose a real cost on the economy.
Meanwhile the stock market has had another bad day. It dropped immediately upon opening to go as low as 2992 in the first 45 minutes, before rebounding sharply during the rest of the morning. The afternoon was bad, however, and it closed at 3024, 1.6% down for the day, even after a surprisingly strong mini rally in the last fifteen minutes of the day. This is only 24 points above the 3000 mark that is supposed to be the government’s intervention level. I think everyone is waiting nervously to hear what the government plans to do. If they intervene decisively, the market will rise, but probably without much conviction. If they do not, the market will probably drop quite suddenly before finding a new floor.